What is Finance?

There are several primary areas of finance. These include:

• Commercial Banking/Financial Institutions
  • Commercial banks, credit unions, insurance companies and countless other financial institutions are an important part of the financial landscape. These institutions deal with financial concerns such as risk management, time value of money, financial intermediation, providing short-term and long-term financing to individuals and businesses, payment processing, and many other activities critical to the financial environment.
  • Banks and other similar financial institutions are among the primary employers in the field of finance.
  • While we will deal with some issues that are of concern to these financial institutions (time value of money, risk/return analysis, types of financial instruments, etc.), this class will not be primarily focused on banking-related issues.
• Investments
  • One of the common images associated with finance is the stock market. The field of investments deals with stocks, bonds, options, mutual funds, futures, and many other financial instruments.
  • Some of the key considerations in the field of investments include valuation analysis, risk/return analysis, diversification, and fit (by fit I mean that what may be a good investment for me may be a poor investment for someone else due to each person's unique set of investment objectives.)
  • There are many career paths related to investments including stock analyst, fixed-income analyst, portfolio manager, trader, etc. These careers tend to be very competitive, demanding, and offer the potential for high income.
• Personal Finance
  • Personal finance deals with a variety of financial decisions made on the personal level. This includes areas such as retirement planning, insurance, personal budgeting (can I afford a new house or new car), and any other financial decision that a person makes.
  • While personal finance is not the primary topic of this course, it is an important issue for everyone AND overlaps with many of the main themes (time value of money, diversification, valuation analysis, etc.) that we will talk about in this class. Due to its importance and overlap with our primary focus, we will spend a fair amount of time this semester discussing personal finance issues.
  • The most common career path associated with personal finance is the financial advisor/planner. A financial advisor works with individuals to help them achieve their personal financial goals. Financial planning is an expanding field and is consistently rated very high in job ranking evaluations due to its combination of potential income and job satisfaction.
• Corporate Finance
  • The terms Corporate Finance, Business Finance, and Managerial Finance are often used interchangeably and refer to the field of finance dealing with financial decision making from a business perspective.
  • Primary topics for corporate finance deal with raising capital (issuing stocks, bonds, or other forms of financing), paying dividends, maximizing value for shareholders, evaluating potential long-term investments that the firm will undertake (such as building a new warehouse), and managing the firm's cash flows.
  • Students with a strong background in accounting are often among the top candidates for jobs in the field of corporate finance.

During the semester we will touch on several of these topics, but our primary focus is going to be on Corporate Finance. In order to do this, we must start by defining the concept of the corporation (firm).

What is a Corporation?

A CORPORATION is a firm owned by many individuals (stockholders) who in most cases have little input in operating the firm. A fundamental component of the corporate form of ownership is the separation of ownership from the process of managing the firm. The owners (stockholders) elect a board of directors who are responsible for hiring management and overseeing the direction of the firm's operations. Corporations account for the bulk of business activity in the US because most large firms are organized as corporations. We will focus on the corporation in our coverage of finance this semester.

• Limited Liability -- Due to the separation between business and the owners, stockholders are not liable for anything beyond their initial investment. When buying a share of stock and becoming an owner in a corporation, you can lose your entire initial investment, but nothing beyond that.
• Easier access to capital -- Corporations have access to the capital markets by issuing shares of stock or issuing bonds. This makes it easier to raise large sums of money for expansion or a multi-year, profitless startup that is anticipated to generate significant profits after the startup stage.

• Higher start-up costs and higher levels of regulation -- Because there is a separation between the owners and the business, there are higher regulatory costs associated with keeping owners informed about business operations. Publicly traded corporations must follow SEC guidelines pertaining to registration and reporting (such as audited annual and quarterly reports)that are costly. According to AMR Research (http://www.amrresearch.com/Content/View.asp?pmillid=20232), it is estimated that US corporations will spend approximately $6 Billion dollars in 2007 in complying with Sarbanes-Oxley, just one of the many regulatory costs associated with corporations.
• Double-taxation -- Because of the owners and the business are treated as two separate entities under the corporate form of ownership, both are taxed. The business must pay corporate income taxes on any income it makes. When investors make money through dividends (a distribution of corporate profits to owners) or through capital gains (an increase in the value of a share of stock) these are taxable. The current tax code taxes dividend income at a lower rate than ordinary income which substantially reduces (but does not eliminate) the impact of double-taxation. Given the volatile nature of tax codes, the impact of double-taxation is likely to fluctuate over time.

While our focus this semester will be on the corporation, many of the same ideas apply to other types of business organizations (such as sole proprietorships or partnerships) as well as personal financial decisions.

Stocks vs Bonds

The two primary sources of financing for corporations are stocks (equity) and bonds (debt). These are also two critical financial instruments which we will discuss in depth throughout the semester. Let's introduce the basic characteristics of these securities (a "security" is just a generic name for a financial instrument) now.

STOCKS are a form of ownership (equity) in a corporation. When you own a share of stock, you are actually a part-owner of the corporation. Large corporations have several million (or in some cases billion) shares outstanding, so when an individual owns 100 shares they own a very small fraction of the firm. For example, Exxon Mobil had 5.7 billion shares outstanding in April 2007 while Google had 311 million at that time. As an owner, you are entitled to a piece of the company's profits (on a pro-rated basis equivalent to the percentage of ownership). The firm can choose to distribute those profits back to shareholders in the form of dividends or reinvest those profits back into the company. When firms reinvest the profits back into the company instead of paying them out as dividends, the value of the firm should increase (assuming the profits are reinvested wisely) which will result in capital gains. Thus, your return from owning stock can come from two sources -- dividends and/or capital gains. Because the dividends and capital gains essentially represent your portion of the company's profits they can fluctuate dramatically over time. Dividends represent the portion of the profit that is CURRENTLY being paid out while capital gains are dependent on investors' expectations of FUTURE profits. Some companies expand rapidly and are extremely successful leading to high returns. Others struggle (or even go bankrupt) and lead to negative returns. As such, the returns associated with stock ownership are highly volatile and risky. A final issue associated with stocks is that there is no maturity date to stock ownership. When you buy a stock, you own it until you decide to sell or the company goes bankrupt. Theoretically, the timeline for this type of security is infinite.

Stock Summary

• Ownership (Equity)
• Variable Cash Flow (Return) Stream -- Dividends and Capital Gains
• Higher risk and (on average) higher returns
• Infinite Time Line

BONDS are a form of debt. When you buy a bond, you are lending the issuer money (in addition to corporations, the government is also a large issuer of bonds). The loan is structured so that you (typically) receive a fixed interest payment (referred to as a coupon payment) every six-months until the bond matures. At maturity, you receive the last coupon payment and the par (or maturity) value. Unlike dividends (which firms can increase, decrease, or discontinue at their discretion), promised coupon payments on bonds must be made to bondholders on time or the company can be forced into bankruptcy. Bondholders are first in the priority of payments and must receive their promised payments before the stockholders get anything. Due to this priority of claims, the fixed cash flow stream (coupon payments and maturity payment), and the fixed time horizon, bonds are considered lower risk than stocks.

Bond Summary

• Debt (Loan)
• Fixed Cash Flow Stream -- Coupon and Maturity Payments
• Lower Risk and (on average) lower returns
• Fixed Time Line

Goal of Financial Manager

The Goal of the Financial Manager is to Maximize the Shareholder Wealth (Side Note -- Sometimes this is referred to as Maximizing Firm Value since increasing the value of the firm increases shareholder wealth.) In order to do this, we must concentrate on

• The Magnitude of Expected Cash Flows
• The Timeliness of Expected Cash Flows
• The Riskiness of Expected Cash Flows

The above idea is a central theme that will underlie everything we do this semester!

Key Points regarding the Primary Goal of Financial Manager

• Note that in the 3 factors impacting firm value listed above we use Cash Flows NOT Earnings (Net Income). While there are many similarities between earnings and cash flows, they are not the same. We should always focus our attention on cash flows instead of earnings. For more on this issue, see the following discussion on Cash Flow VS Earnings.
• The word Expected is a critical component of the the three factors. While what has happened in the past is not irrelevant, the relevance is based on how it might impact future cash flows. Investors base their valuation decisions on the future of the firm. When analyzing stock price changes to information, it is always essential to consider what the new information is RELATIVE TO what expectations were.
• The three key elements (magnitude, timeliness, and riskiness) are not individual goals. Everything else being equal, higher cash flows are preferred to lower, less risk is preferred to more, and earlier receipt (later payment) of cash flows is preferred. However, things are rarely equal. Increasing the magnitude of cash flows usually means taking on higher risks. Less risk usually means lower expected cash flows. Thus, we need to keep the primary goal (maximize firm value) in mind and realize that the interaction of risk, magnitude, and timeliness are more important than any one separately.
• The concept of maximizing firm value is not specific to finance. The purpose of marketing, internal accounting, personnel decisions, production, etc. is to maximize firm value. When you are hired in any field, the rationale for that decision is that the company plans for you to directly or indirectly increase its value.

Social Responsibility and Ethics

Social Responsibility refers to the concept that businesses should be actively concerned with the welfare of society. Examples may include establishing scholarship funds, contributing to the arts, or "matching" employees contributions to charities.

Ethics refers to standards of conduct or moral behavior. Examples may include exceeding minimum safety requirements for employees, abiding by (or exceeding) regulations regarding environmental issues, honoring not just the letter, but the spirit of contracts or verbal agreements with customers and suppliers.

Social Responsibility and Ethics are NOT inconsistent with the maximization of firm value. While there is a cost to engaging in ethical and socially responsible behavior, there are often benefits in goodwill and public relations that may more than offset those costs. There is strong evidence that engaging in Social Responsibility and Ethics is highly consistent with maximizing shareholder wealth. A recent study by Marc Orlitzky, et al (2003) reviewed 30 other studies examining social responsibility and firm performance. They find a consistent pattern that social responsibility is correlated with firm performance. However, we must remember that while social responsibility is consistent with our primary goal (maximizing shareholder wealth) it is not the primary goal in and of itself. While it seems wrong to say that a corporation can spend too much money on trying to improve the welfare of society, keep in mind that the owners of the corporation are the stockholders. When a corporation writes a large check to a charitable organization, essentially the managers of the corporation are deciding where/how to spend the stockholders' money. It would be fairer to let those stockholders decide how to allocate their money.

For an example of some firms that rate high in social responsibility and ethics, take a look at Business Ethics list of 100 best corporate citizens.

International Issues

One critical aspect to maximizing firm value is recognizing that business is global not national. There are currently less than 300 million people in the US and over 6 billion people on the planet. Marketing solely to the US excludes approximately 95% of potential customers. While not every customer has equal purchasing power, it makes no sense to exclude 95% of your potential customers. From an economic standpoint, the majority of economic activity is also outside the US. According to the Worldbank, in 2005 the US had GDP of $12.5 Trillion while global GDP was over $44 Trillion. This means that over 70% of economic activity occurs outside the US. In addition to our customers, many of our competitors and/or suppliers may be based internationally. Therefore, if we ignore the global aspects of business, we are not maximizing firm value.

Agency Relationships

An Agency Relationship exists any time one or more people (the principals) hire another person (the agent) to perform a service and then delegate decision making authority to that person. The central issue with agency relationships is potential conflict of interest between the principal and the agent or between two or more groups of principals.

Agency problems can cause difficulties in maximizing firm value. The two major agency conflicts (we will focus on the first one) are

• Managers - Stockholders (owners)
• Stockholders (owners) - Creditors (Bondholders)

Stockholders hire managers under the goal of maximizing firm value. Doing so will maximize the wealth of stockholders. However, the manager may operate under the goal of maximizing his/her happiness instead of firm value. This may take the shape of overspending on perks (office decorations, company jets, etc.) or on minimizing risk to protect job security even at the expense of positive returns. There are many ways to try to control for agency costs including:

• The threat of firing -- While most people understand the threat of being fired, this is not an overwhelming threat to most top managers (although it is more credible for other employees of the firm). Many CEO's get rich compensation packages(Golden Parachutes) even if they are forced out of their position. Also, there are some instances where the Board of Directors (the people responsible for hiring and paying the CEO) may be "friendly" to the CEO. In some cases, the CEO is also the Chairperson of the Board of Directors.
• The threat of takeover -- If a firm is purchased by another firm, the acquiring firm will often replace upper management. One reason for a takeover is that the management team is not maximizing firm value. If others feel that they could run the firm in such a way as to make it more valuable, they may buy the firm with the intention of bringing out this additional value. However, takeovers are not cheap. Most acquiring firms pay premiums of 20% to 50% to complete a takeover. For example, if the stock price before the takeover is $50, the takeover offer may be $70 per share. This leaves a lot of room for mismanagement. If my firm's assets are worth $60 per share under optimal conditions, but under my management are only valued at $50 I am not maximizing firm value. However, it may not be bad enough to justify a takeover. Also, many firms use defenses (Poison Pills) that make takeovers harder to execute. For example, there may be a clause in the debt agreements that all debt becomes due in the event of a takeover.
• Influence of large shareholders -- This is a relatively new form of Corporate Governance that is starting to gain prominence. Large institutional investors may try to rally shareholder to pressure management to run a more efficient operation. If a few large shareholders can act in unison,they can create enough pressure to make necessary changes.
• Compensation packages -- The best way to make managers interested in maximizing value is to pay them based on their stock performance. This is often accomplished through payment with stock options (the right to purchase shares at a fixed price even if the stock goes higher). Also, many CEO's own significant amounts of stock in the company they work for. Caution must be exercised that compensation is based on maximizing value and not other factors. For example, compensation based on the size of the company's assets may create incentives to make investments that increase assets without adding value. Also, compensation based on meeting sales targets may get met by selling items for a loss (which reduces firm value). Finally, stock options may be the most popular way of trying to align the interests of shareholders and managers but they also have some serious flaws. Specifically, the way many options packages are granted they reward short-term fluctuation in the price of the stock more than long-term value creation. There have also been issues related to the timing of option compensation that has acted more as a wealth transfer to executives rather than an incentive. Compensation packages must be carefully designed to align the interest of management with the objective of creating shareholder wealth in order to minimize agency conflicts.

Another agency conflict arises between the two principals, the stockholders and bondholders. Because of the difference in the way stockholders and bondholders are compensated, their attitudes towards a "worthwhile" investment may be different. This can lead to conflicts between which projects to undertake. Generally, bondholders prefer low-risk investments (as their potential return is limited) and stockholder prefer higher risk investments (assuming the higher risk is compensated by higher return).

The better we can control these agency problems, the better our chances of maximizing firm value